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Overlaying Strategies in Managed Futures: Does it Help an Investor?

8/27/2011

1 Comment

 
By Mark Shore

I was recently interviewed for a few articles and the topic of overlaying strategies was discussed as a potential component of a managed futures portfolio. Realizing this topic is not discussed as much as it should be; it opens the door to a more in-depth understanding of managed futures. It is a topic I cover in my managed futures course at DePaul University.

Discussing this topic of overlaying strategies really gets to the heart of one question that keeps reappearing, “why are CTAs non-correlated to equities?” This is a very simple question to ask and is asked with high frequency. But the answer includes many topics to properly answer it. As Matt Davio recently stated, it’s the “special sauce” in understanding managed futures. One of the topics of the special sauce is the utilization of overlaying strategies.

For example, let’s assume the following of a fictional CTA (Commodity Trading Advisor):

- The CTA trades a diversified systematic trend following model (Core model) in 20 markets in both financial and commodity futures.

- The model can be long, short or neutral in any of the 20 markets of its portfolio. (Neutral means the portfolio does not hold any positions in a particular market.)

- The size of each position is not static, but may be dynamic based on some formula built into the trading algorithm. For example: our fictional CTA may trade a 20 contract position in 30 year bond futures. On the next trade in that market, they may hold more or less contracts based on their trading strategy.

- Stops and other risk management tools may be used utilized for risk management purposes

The above assumptions imply the portfolio at any given time could hold positions in zero to 20 markets. And due to the dynamic nature of being long, short or neutral and the utilization of various risk management methods the portfolio may be very fluid causing changes in the portfolio due to the strategy components. Thus the equity curve of the portfolio creates a non-correlation potential to equities.

Now that we have conquered the understanding of the Core model, let’s move forward in time and assume the CTA now allocates within their fund to a few other trading systems that may involve longer or shorter time frames or some other variations.

Perhaps the CTA allocates 70%, 80% or 90% to the Core model and allocates (or overlays) the balance of the fund to the other systems. The logic of overlaying other systems is to smooth out the returns of the Core model.  By overlaying various systems into one fund, the CTA has in essence organically created a quasi Fund of Fund.

The investor as well as the CTA has to ask: Does the overlay smooth the returns? Does it reduce volatility? Or asked another way, does it reduce the negative volatility (tail risk)? Keep in mind there is a difference between positive and negative volatility. We will leave the discussion of parsing volatility for another time.

By allocating to multiple systems it potentially maintains a fluid and/ or dynamic portfolio, thus equating to potential tendencies for non-correlation to equities. From the CTAs perspective they are not only managing a portfolio of futures markets, but they are also managing a portfolio of portfolios. One may call it a second derivative of the portfolio.

In times of economic stress, nervous investors tend to run for the exit door simultaneously causing the correlations of many sectors and asset classes to increase. 2008 is great example of investors running for the exit door. If a manager is trading multiple markets from a long, short or neutral perspective and potentially overlaying strategies; could this investment be non-correlated to equities?

In summary, not all CTAs overlay trading systems into a fund or portfolio, thus one more reason why CTAs differ (see Decoding the Myths of Managed Futures). This is not a judgment call of a good or bad idea of risk management. But simply as part of the due diligence process, the investor should know if the CTA is overlaying systems, to understand the concepts of those systems and the source of returns of the fund and how the overlay may offer another potential method of non-correlation to equities. Understanding this topic gives an investor a deeper understanding of the managed futures industry.

Ultimately the investor has to determine if the investment adds value to their current portfolio.

Copyright ©2011 Mark Shore. Contact the author for permission for republication at [email protected] www.shorecapmgmt.com Mark Shore publishes research, consults on alternative investments and conducts educational workshops. Mark Shore is also an Adjunct Professor at DePaul University's Kellstadt Graduate School of Business in Chicago where he teaches a managed futures/ global macro course.

Risk Disclosure:
Past performance is not necessarily indicative of future results.  There is risk of loss when investing in futures and options.  Always review a complete CTA disclosure document before investing in any Managed Futures program.  Managed futures can be a volatile and risky investment; only use appropriate risk capital; this investment is not for everyone.  The opinions expressed are solely those of the author and are only for educational purposes. Please talk to your financial advisor before making any investment decisions.

1 Comment
Michael Agne
9/4/2011 08:55:21 am

I do not think an investor would benefit from a single CTA overlaying strategies. The idea about managed futures is to diversify a portfolio, which in of itself provides diversification and the ability for the investor to reach markets that traditional investing does not. Overlaying strategies in my opinion does nothing for the investor, does not smooth volatility, in fact it may increase volatility if the cross correlation between the overlayed CTA programs becomes more correlated. In this day and age the more and more systematic programs that trade multiple products try to become "uncorrelated" and "more diversified" actually become more correlated and less diversified as trades get crowded and everyone tends to flock to the same boat, jump ship at the same time and correlate markets based upon some theoretical model. In my opinion systematic algorithmic modeling is not some sort of holy grail of investing, it seems as if we humans tend to think we can control chaos when in fact the markets that we so rationally try to exploit, tend to do just the opposite, exploit the basic human mentality and expose its inherent flaws and irrationality, unfortunately the investment community learned nothing from LTCM. The fact of the matter is investing is risky and you have to be willing to lose everything, or else don't even participate. This whole thing as we can see today can destroy more than it can create. Right now we have to rely on fictitious central bank purchases of all assets to just make the appearance as if they are worthy assets or as if the market is actually fundamentally strong. That is not going to change and the volatility that comes along with manipulating markets, in no way allow for any diversification to offset the potentiality of loss. So the investment community needs to come to the rationality that in a low interest rate environment all investments are susceptible to great swings in volatility that no diversification will stop. Caveat Emptor

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